Royce and Ian discuss the latest Fed announcement and how some of the accompanying projections seemed inconsistent with others. They talk about why the new forecasts could be subject to more change than usual, and how that fits in with the Fed’s new reaction function. They conclude that this leaves more room for markets to ‘fight the Fed’ dot-plot than in the previous cycle. The conversation then moves on to an analysis of the relative timing and magnitude of Bank of Canada and Fed rate hikes priced into markets. Royce asks Ian whether he expects any hints about BoC tapering from Deputy Governor Gravelle in next week’s speech. Ian closes the show with a final question about Canada’s housing market, seemingly unrelated to the rest of the episode.
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Ian Pollick: We have the Fed that pay tribute to some of the good, but still sent a very dovish message. Dovish message. See, I just pulled a Royce. Hey Royce, how are you?
Royce Mendes: Good, my friend. How are you?
Ian Pollick: I'm OK, buddy. Let's jump into this because there's a lot to digest, a lot of talk about. Obviously, the starting point is the Fed from two days ago. Let's kick it off with the survey of economic projections relative to I think what the market was expecting relative to what was delivered was a bit of a disconnect. Why don't you walk us through three things? Number one is that economic forecasts, growth and inflation, in particular within the context of this is the first dot plot from an AIT perspective. Number two was the dots themselves. And then number three was the characterization of the economy. So, you know, what are your big thoughts here?
Royce Mendes: So starting with the growth in inflation forecasts, look, they upgraded their growth forecast pretty significantly over the next two years. They're looking for growth of 6.5% in 2021. That's Q4 over Q4. And then 3.3% in 2022. That's even hotter than what we had penciled in. Now, if you look at what that translates into for inflation, it's actually not that much. Chairman Powell stressed during the press conference that if you look back to 2018 and 2019, the unemployment rate was below 4% and you still weren't generating above target core PCE inflation. Now, could this time be different? Actually, maybe, yes. We're seeing signs that labour unionization rates might be rising, minimum wage hikes could be coming down the pike. And you have sort of this pause in globalization, maybe not a deglobalization trend anymore, but at least a pause in globalization, which is, again, inflationary. So for those three reasons, the Fed is potentially underestimating what might show up in inflation. Now, curiously, in 2023, they only show a growth rate of 2.2%. Now, you might say, well, that's roughly around potential growth, but they're showing a growth rate around potential while at the same time they're not showing any rate hikes. So the economy is slowing down, but for a reason other than their own policy. Where the disconnect sort of starts to show up is even though we could argue that their inflation forecasts are a little bit light, they're still averaging above 2% for the next three years. And that's where I think it signals that their reaction function has changed more than we or the market might have been anticipating.
Ian Pollick: So let's talk about that for a second, because if we were to go back, say, 2014 to 2018, we're in a low inflation trend like growth environment. Interest rate hikes were very slow at the start. There was one in 2015 one in 2016. And then all of a sudden you went to this synchronized boom and central bankers did what they never do is they do exactly what they said and they hiked rates and then ultimately tripped the economy up. We know that from an average inflation targeting perspective that it's no longer sufficient to expect inflation to exceed or breach target, nor is it sufficient to assume that the output gap is simply closed. They have to see evidence of it. But when we look at the survey of economic projections and then we overlay it on the dots, the consistency seems to be that the run rate or the allowance of moving the economy to a very high pressure scenario seems to be quite different than it was in the past. Is that how you would see the reaction function changing?
Royce Mendes: You hit the nail on the head. At this point, they don't want to make any moves based on just forecasts. And one thing maybe you missed was that they certainly don't want to make any moves based on forecasts of the Phillips curve, which you can see Powell and Powell is Powell is consistently. Let me start that again. Sorry.
Ian Pollick: What? (laughs)
Royce Mendes: You can actually leave that in. I don't know why I said Powell and Powell (laughs). Which Powell is consistently deemphasizing. But what I will say is that they don't want to make any changes based on forecast. And I think that's sort of also plays into, how should I word this? In some way, the Fed didn't want to have to show a rate hike in 2023, right? They want to make sure people understand the message that there has been a regime change and there is going to be above target inflation to make up for the lack of inflation over the last cycle or the last few years or whatever they decide it to be. And this drives that point home even harder. When I look out at the forecast, though, do I think if, let's say inflation starts to heat up, it starts to show up in some of the more underlying measures of inflation, could they pull forward those forecasts? Absolutely.
Ian Pollick: Of course they could. But, you know, the thing that I struggle with here, Royce, when I'm looking at these forecasts and I get conservatism. And I understand to a certain degree why they did what they did. What is bothering me is that the reaction that we're seeing in bond markets is such that, you know, you went through this period very late last year where everyone was listening to the Fed saying, listen, we're not doing anything for a very long time, but we're going to generate a very high pressure outcome. Ok, fine. So we had breakevens in market based inflation compensation really lead the selloff because people thought, well, they're not tightening rates, therefore, they're going to allow inflation to overshoot. Then you kind of got into the early part of this year. Growth numbers start to look very good. Markets brought the Fed forward and that allowed this transition away from breakevens leading the selloff to real interest rates, which just meant that there was more of a growth narrative in the bond market. But I get concerned because as of yesterday, it's almost like we've reshifted back to that, you know, August 2020 to 2021 environment where now we're generating this inflationary discussion that's really steepening the curve. But doesn't that tighten financial conditions prematurely, which is at opposite ends of stoking the recovery, which is what they're trying to do by not raising rates?
Royce Mendes: It does. But as he pointed out yesterday, he's not really concerned about the tightening thus far in financial conditions. And I don't think he'd be overly concerned about the tightening at the long end that we've seen over the past couple of days. His job is to signal that they are going to get those inflation expectations higher and he's actually done just that. Now, the question for you is, how much longer can the market fight what the Fed is communicating?
Ian Pollick: So, you know, the old adage, don't fight the Fed. But I think the market's about to dig its heels in for a pretty big fight here. And, you know, I think it's just this reflection that because under the new framework that they really can change their mind on a dime once they have this understanding what the data is evolving into.
Royce Mendes: It's evident. They're really hesitant about making any changes to the stance of monetary policy based on forecasts. And that showed up in both the summary of economic projections. But in his press conference, he stressed that.
Ian Pollick: So that's the point. And first of all, I'd say he did a really good job in the press conference, probably the best job I've seen him do since he took over the chairmanship. But what I think is going to have to happen in the bond market is that this is not a situation where it's a game of attrition and the Fed ultimately wrestles the market to submission. Because things can change at such a moment's notice that the Fed is now on a real time reactionary function, that the market cannot get to acquiesce with this idea that the Fed narrative is the overarching narrative. So I expect that this game of tug of war is going to persist for a little bit. And you know when I think about the path of policy and let's talk about this for a second. As of right now, the market has the Fed finishing their rate hike cycle just under 2% by 2025. The timing of rate hikes have been pushed out a little bit. So we're talking about early 2023. The two questions I have for you are, number one is, can we realistically, realistically expect a rate hiking cycle to last until 2025? And can we realistically expect that the Fed's not going to do anything for the next 16 months? No. I want to know.
Royce Mendes: Could it be within the bands? (laugh) It could, it could happen, yeah.
Ian Pollick: But I can tell from your voice you're not overly convinced, so.
Royce Mendes: No, because I don't think this rate hiking cycle is going to be as long as the last one. And I'll say this, because last time they were hiking rates ahead of when the evidence was showing up. So Yellen had to pause and wait for better data to roll in before hiking again and then wait again to see how the economy reacted. This time you're going to be actually playing a little bit of catch up. They don't want to say that, but they're going to be playing a little bit of catch up. And I would expect that the rate hiking cycle should be shorter. Now, when can they move? Can they actually stay on hold for the next 16 months? That's well within, I would say, forecasts based on reality and the range of forecasts. But I think it's likely that they probably need to move a little bit earlier. This discussion is very hypothetical, I think a discussion that hits a little bit closer to home. And actually we can have a little bit more of a deep discussion with, is the relative timing of the Bank of Canada versus the Fed. So what's priced in for the Bank of Canada and what's priced in for the Fed right now? And we can go from there.
Ian Pollick: So, you know, a time of discussion here in the studio. The Bank of Canada's priced to start hiking rates kind of in June 2022. If you kind of build out the forecast to the end of 2025, which is where it starts to slow down. So it's kind of like two hikes in 22, three hikes in 23, two hikes in 24, one hike in 25, leaves you with a 2.25 overnight rate, which remember that's 50 basis points above where we reached the peak in the last cycle. And the Fed is, it starts later, but then it goes a bit faster. So when I think about that, I was really hoping when the survey of economic projections was released that it would reduce some of the optical pressure coming into Canada on the timing and pace of our own hikes. And clearly that didn't happen. And if anything, it exaggerated a little bit. So for you, the question I have is, we're now in a situation where not only are we price to go meaningfully before the Fed, but meaningfully faster. I didn't have a hard time going before the Fed. I have a bit of a hard time seeing the bank hiking twice before the Fed even started its own cycle.
Royce Mendes: But I think it's even like five times by the end of 2023. And the Fed is only priced for what, two?
Ian Pollick: We have, I think it's seventy five basis points price at the end of 2023. You have very large disconnects opening up is the point.
Royce Mendes: And you're starting from a point where the Canadian dollar is, in our view, strong. So that is not exactly conducive to the Bank of Canada needing to tighten financial conditions materially faster than they would in an environment where the Canadian dollar was, let's say, trading significantly weaker against the US dollar. I think the starting point matter here, and it seems unlikely that you're going to get in that environment five hikes from the Bank of Canada and only two and a half from the Fed.
Ian Pollick: But that's why I keep coming back to this idea that when you're operating in the Just-In-Time policy environment, you can't call shenanigans on the profile for the Fed just yet, because if you get pulled forward. In a week or two weeks, this whole thing can be moved.
Royce Mendes: Right, right. Right.
Ian Pollick: So that's a very hard situation for investors. And I think in terms of guidance, what we can do best is just try and give our advice. But when we think back to some of the risks for Canada in the April MPR that's coming up. Obviously, we have the ECB, which was talking a bit more dovishly. We have the Bank of Japan, which is still a bit dovish. We have the Fed that pay tribute to some of the good, but still sent a very dovish message. Dovish message. See, I just pulled a Royce. I think there's broad based expectations that in the April MPR, if I had to socialize what I think my main conversations with investors are it's three fold. Number one is you're going to get a taper. Number two is you're going to get a change up in their forward guidance with the removal of the calendar based 2023 guidance. Another number three, you're just going to have this wholesale adjustment to the forecasts. Are any of those three at risk in your mind, given what we've just learned from the Fed?
Royce Mendes: Yeah, I think the timing of the closing of the output gap, which we had been expecting it to be pulled forward into 2020, the tail end of 2022, but still 2022. There's a risk that they sort of pull a Fed here and just leave it at this point where it's very early on in the recovery. And we actually may be about to embark on a third wave of the virus in Canada. Maybe they just leave the timing of the output gap closing in 2023 so as not to spook markets or not to see any further pulling forward of expectations. Now, Deputy Governor Toni Gravelle does have a speech next week. It'll be on market functioning. It's specifically titled: The role of the Bank of Canada in responding to market wide stress. Do you think there's any potential that hints at the tapering you're expecting to be announced in the April MPR?
Ian Pollick: So I think the title of the speech is very apropos for that particular deputy governor, given that he has one of the most wide degree of market knowledge. And I think if anyone is going to drop a hint about a taper, that would be the type of environment and platform and speech that you would do it. You know, one of the reasons that we think the bank is tapering isn't just a function of the fact that the economy is growing, therefore it needs less stimulus. A lot of this is technical in nature. You are buying too many bonds, you are distorting liquidity. And we've talked about that many times. So I think that there's a risk next week that we do get some indication that the bank is considering changing up the way that its conducting its QE purchases. And I think that under such a platform or title, it's easier to come across as, this is not a stimulus move. This is more of an adjustment to the technical outlook.
Royce Mendes: Let me ask you a question here. Since we're talking about tapering, what are your thoughts about the Fed?
Ian Pollick: Listen, again, this is an environment where I'm not going to put all my faith in what the Fed's characterization of the reaction function is today. I think it can change very quickly. And I think even in the most conservative estimate of not hiking through 2023, you still have a very big sequencing that needs to happen. And the first thing that has to happen is you have to announce a taper, then you actually have to taper. Then you have to go through multiple instances of reducing the pace of purchases and get to a spot where you're just doing reinvestment. I think the risk here is that given what we learn on Wednesday, that we don't get a tapering announcement until sometime in 2022. But my gut tells me that I think we're OK, still expecting around the summer of this year to expect some type of signal, and he did stress that in the meeting yesterday, that you will know when we are giving you a signal. So I don't think they're being coy about it. They're going to be as open as possible. I just don't trust in March 2021 that we're going to completely write off the next nine months of the year that's an inactive policy agenda.
Royce Mendes: Right. If we're talking about in the context of bond yields, how much do you think the Canadian taper matters and how much do you think the US Fed taper matters or has a lot of what the reaction would have been to tapering already being pulled forward in the selloff we've seen in fixed income.
Ian Pollick: So I always get the question, you know, how high can rates rise? And ultimately rates can go as high as they want, but you need some framework to think about it.
Royce Mendes: That's a great insightful comment. They can go as high as they want.
Ian Pollick: They can go as high as they need to.
Royce Mendes: All right. (laughs)
Ian Pollick: Anyways, thanks for that, ivory tower. No, seriously, you need a framework for thinking about it. So when I look at, for example, breakevens in the US, 10 year break evens are roughly about 2.3%. If you translate that into core PCE terms, you're still talking about one nine core PCE. So you're about there. You could probably have a bit of an overshoot. So if the Fed is talking about what was core PC in the set, two one?
Royce Mendes: In which year?
Ian Pollick: 2022?
Royce Mendes: Core PCE in 2022 is just 2%.
Ian Pollick: OK, so in 23 it's two point one, yeah?
Royce Mendes: Yeah that's right.
Ian Pollick: OK, so let's say on average two oh five over the next two years. Then that means that 10 year breakevens in the US, they can rise another 20 basis points before they start to become inconsistent with the core PCE forecast the Fed lined out. And that 10, 20 basis point selloff or rise in breakevens probably translates into a twenty five basis points selloff in 10 years. So you're realistically talking about kind of 2% as a near term cap, which would be very consistent with the inflation profile. I think that's why I've been thinking about it. Another way to think about it, too, is that in Canada, when I look at a five year yield, it has to make sense within the context of where we think the bank's going to finish its policy cycle. And what that allows us to do is kind of build out this path dependent repo understanding of what I'm earning, owning this bond and what the breakeven is to be short. And basically right now, if you believe the Bank of Canada in 2025 is going to end policy at two and a quarter, five year yields in Canada are very close to being fully cooked. So you're getting to a situation now where the selloff is getting close to levels that once it goes above it, you really are starting to divorce yourself from some of the governing forces of underlying macro. And what that tells me is that any potential impetus that a taper in Canada could have, I don't think it's going to be big. I never really did. The US probably matters more. Arguably it does. So I'm not convinced just yet that we've seen the peak in yields year to date, but I think we're very close.
Royce Mendes: What are you seeing in markets? What's being priced in for like five year, five years in terms of a nominal neutral rate?
Royce Mendes: Were you spying on me again, Royce?
Royce Mendes: No, I was on the call, I think. (laughs)
Royce Mendes: Oh, were you, OK? Yeah. So that's why, you know, that's a bit creepy as well. But when I was looking at five year, five year nominal yields in the US, you're kind of like that two seventy level right now. That is a level where, you know, over time, where you think about nominal neutral, 10 year yields don't really divorce themselves for very long periods of time relative to where nominal our start is. So you're getting close to this situation where you're going to entice people back into the market at some point.
Royce Mendes: Right. I think there's some room, actually, and we can go into this another day. But I think there could be some room that actually nominal neutral rates might have risen during the pandemic. It's not what you would tend to think might happen. But your point that it's almost fully cooked in the five year is very interesting to get up to two twenty five. That's interesting.
Ian Pollick: So Royce, let's talk about Canadian housing before we wrap up the episode today. We learned two things over the past kind of 48 hours that are diametrically opposed. Number one is Canadian housing was ripping last year. It was up 17% year over year. At the same time, Canada's population growth was the slowest since 1916. Obviously, we know that immigration was slowing down because our borders were closed, but that's also a very vital component of maintaining such a buoyant housing market. How do we think about that?
Royce Mendes: There's been a perverse impact from the pandemic on Canada's housing market. And you see it most clearly in the suburbs and single family, low rise housing. People have had more time and more money to spend on their homes. And you've seen that reflected in the numbers. People have been leaving condos and urban cities and migrating further out to the suburbs because they wanted more space for work or because their kids were home and they had more money because they weren't spending on vacations and restaurants and interest rates were very low.
Ian Pollick: And, and, and, and.
Royce Mendes: Yeah, you saw that part of the market just explode. Now on the flip side of that, you saw some, I would say, weakness or softness in condo markets, but there wasn't a lot of activity, so prices didn't actually move that much. But now what I would argue is that we should be expecting something of a normalization in the coming months. You're already starting to see in the condo market demand start to pick up. I would expect, as people start spending less time at home and start spending more money on things other than shelter, the demand for single family homes might cool off and you should see a more balanced market similar to what we saw pre pandemic. I'm not sure of the timing of that adjustment, but after everything we've seen during the pandemic and all of the research we've done on why those moves happen, it does suggest that it was tied to the pandemic. Now, if we start to make up for the lost immigration, that adds an extra layer of demand for overall housing in Canada and adds an extra layer of support, it's a safety net. So there's no doubt that the Canadian economy and financial system are more vulnerable as a result of the latest increases in housing prices and the amount of money that has flowed into that market. But I think what we should be expecting is somewhat of a normalisation with the safety net of immigration coming back, not the type of maybe worst case scenario risks that we can all imagine.
Ian Pollick: Thank you for that super verbose answer. Listen, I think this is a-
Royce Mendes: I mean, do you want to disagree with that? Do you have a different opinion?
Ian Pollick: I don't even, I don't want to touch that. Listen.
Royce Mendes: It's unclear why you asked the question, because it has nothing to do with our podcast. (laughs)
Ian Pollick: Well, listen, you know, I think it's really important to think about.
Royce Mendes: You're in the market for buying a bigger house, aren't you?
Ian Pollick: I'm in the market for ending this podcast right now. So, listen, everyone, thank you very much for joining us. And unlike prior episodes, remember, there were bonds harmed in the making of this podcast.
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